How To Find Industries With Great Stock Potential

How To Find Industries With Great Stock Potential
Stéphane Renevier, CFA

4 months ago2 mins

Return on Invested Capital (ROIC) is like the financial heartbeat of a company. It reveals how effectively a firm uses investor money to add value to the business. It measures the profit generated from every dollar of capital invested, highlighting a company's current efficiency and profitability, while also hinting at its potential to create value, maintain margins, and sustain competitiveness over the long haul. Put more simply, ROIC is a big deal.

Different industries have different ROICs, as you can see from the chart. Telecommunication services, utilities, energy, transportation, and metals and mining typically have lower median ROICs (blue dots). And pretty consistently too, as you can see from the small difference between the high and low values they’ve had in the past (black bars). These industries are big, require a lot of capital to operate, and face a ton of rules, which can limit their profitability.

On the other hand, tobacco, household products, leisure equipment, pharmaceuticals, and software all tend to have the highest ROIC – although with a wider variation. That’s because those companies tend to have strong pricing power, thanks to high barriers to entry (tobacco, pharma), strong branding and consumer loyalty (household products and leisure equipment), scalable business models (software), and generally low capital expenditure requirements.

If you’re fishing for stocks in these industries, you’ll find fertile ground with high-quality companies with solid potential for earnings growth. That’s why top investors view ROIC as one of the most important metrics: it’s a direct driver of profit growth. Put simply, ROIC times reinvestment rate (i.e. how much of those profits are reinvested in the business) equals profit growth. All else being equal, a higher ROIC translates into higher profit growth and higher returns for investors.

But there are caveats. First, not all companies within those industries have high ROICs, so do your research before you dive in. Second, keep an eye on that reinvestment rate: many of the industries with the highest ROIC have fewer opportunities to reinvest their profits. And if they don’t reinvest, they likely won’t grow their profits as much. It’s important to screen not just for high ROIC companies, but also for the ones with ample opportunities for growth. Last, make sure you don’t overpay for ROIC. If you follow hedge fund legend Joel Greenblatt’s magic formula, you should do OK.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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